China’s largest trading partner remains the EU, making a US$ peg sub-optimal

SDR currencies offer the best liquidity for intervention or speculation

International investment will be dramatically enhanced by full convertibility

I’ve changed my view of the importance of the RMBs inclusion in the SDR. Initially I thought this a purely symbolic action but, having discussed the issue with several economists and ex-Central Bankers (including one from the PBoC) I believe this a logical move towards free convertibility of the RMB.

For many years the RMB has been pegged to the US$. During the early part of this century it rose relative to its neighbours. This was not such a great imposition on the economy since annual GDP growth was still in double figures.

After the great financial recession of 2008 things changed. New economic policies focused on increasing domestic consumption. At the same time the Chinese economy began to slow dramatically as a result of over-investment, especially in primary industries, meanwhile, the benefits of cheap labour, which had driven China’s mercantilist expansion during the past 25 years, showed signs of fatigue.

After 2008, the US embarked on aggressive quantitative easing which eventually began to foster new domestic employment opportunities – in turn leading to a recovery of the fortunes of the US$. Earlier this year the PBoC devalued the RMB albeit to a small degree.

If you were the PBoC what would you do?

China is rebalancing towards domestic consumption at a pace which would be almost inconceivable in any other country. The implications of this shift include an increase in imports and a structural adjustment in the momentum of the trade surplus. China is moving on from simply being the world’s manufacturer to become a trading nation. A freely convertible currency would reduce frictions in trade and encourage foreign direct investment. The downside to this regime change is the volatility of the exchange rate.

At $3.5trln the PBoC has the largest foreign reserves of any Central Bank. This has primarily been a function of their peg against the US$, although they have actively sought to diversify in to EUR and even the “barbarous relic” gold. During the last 18 months the bank has drawn down on some of those reserves (they peaked at $3.9trln in May 2014) as it managed a devaluation versus the US$ which has fallen from RMBUSD 6.05 in January 2014 to RMBUSD 6.49 today (8-12-2015).

Has the benefit of the US$ peg now run its course? During the period of strong – export led – growth, China was under significant international political pressure to allow the RMB to rise against the US$. The perception is that they resisted international interference, but over the last 20 years the RMB has risen by around 30%. Nonetheless, market commentators immediately seized on the devaluation – especially since August – as a sign that the Chinese were engineering an export led recovery at the expense of the US. This 2013 paper from the Bundesbank – China‘s role in global inflation dynamics suggests there may be some substance to these concerns:-

The overall share of international inflation explained by Chinese shocks is notable (about 5 percent on average over all countries but not more than 13 percent in each region). This suggests that monetary policy makers should take macroeconomic developments in China into account when stabilizing domestic inflation rates; (ii) Direct channels (via import and export prices) and indirect channels (via greater exposure to foreign competition and commodity prices) both seem to matter; (iii) Differences in trade (overall and with China) and in commodity exposure help explaining cross-country differences in price responses.

Nonetheless, the authors note that, between 2002 and 2011, the “supply shock” from cheap Chinese goods explained only 1% of changes in consumer prices outside China, whilst the “demand shock”, from rapid Chinese, growth accounted for 3.6% of changes in global consumer prices. 95% of the variation in global inflation were due to non-Chinese factors.

As the Trans Pacific Partnership comes into effect, China needs to embark on a series of bilateral trade agreements. After the US, its largest trading partners are Japan, South Korea, Taiwan, Germany, Australia and Malaysia, however, as a currency trading block the Euro Area is preeminent.

There are two alternatives to a US$ peg, the first is to manage the RMB effective exchange rate, but this would be expensive due to the multiple currencies involved, the second option is to peg the RMB to the SDR basket. Both politically and economically this acknowledges China’s position as the second largest economy. It also heralds another incremental change in perception about the pre-eminence of the US$ as a reserve currency.

The RMB will be included in the SDR from October 2016. As the Chinese administration moves towards free-convertibility it is likely that they will start by widening the degree to which the currency can fluctuate. By managing the RMB versus the other SDR currencies they can take advantage of the liquidity these currencies provide and the lower volatility that the SDR basket has relative to its constituents. This will also allow the PBoC to intervene to stem the largest speculative currency flows. Table below shows the annual level of trade by region (2011):-

In 2014-15, China experienced five consecutive quarters of capital outflows for the first time since 2000, and the annual volume of outflows is at a record level. If growth expectations continue to soften, this trend may continue in the near future.

China has been an active investor in Africa and other resource-rich regions, but, as its competitive advantages from labour dissipate, external investment will become far more important. Another reason to allow full convertibility.

Technical issues and challenges

The two requirements for joining the SDR are; being a larger exporter – which is no issue for China -and having a freely accessible currency. They still have some way to go on the latter, but China now has more than two dozen swap lines with foreign central banks, has promoted offshore trading and abolished quotas for foreign central banks and sovereign wealth funds investing in mainland bonds.

RMB fixing – the PBoC as a participating SDR central bank, must provide the IMF with a daily fix. Currently there is a gap between domestic and the offshore RMB rate, closing that gap will be an operational challenge.

Given China’s export prowess, it suggests the yuan should be a major currency in the SDR. However, as a reserve asset, it is very small. The IMF estimates the yuan’s share of reserves at a minuscule 1.1%.

Spencer Lake, global head of capital financing at HSBC, one of the banks that arranged the sale, called the transaction a milestone in the internationalisation of the renminbi, noting that it was the first debt offering in any currency from the PBoC outside China.

“This strategic move demonstrates the clear commitment by the Chinese authorities to grow the offshore bond market and the confidence in the City of London as a leading renminbi hub for future activities,” he said.

“The PBoC bond will give a genuine boost to liquidity, market confidence and provide investors with the quality that they demand.”

If one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 20% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $3 trillion.

That, as we suggested three weeks ago, may help to explain why round after round of liquidity injections (via RRR cuts, LTROs, and various short- and medium-term financing ops) haven’t done much to boost the credit impulse. In short, banks may be quietly soaking up the funds not to lend them out, but to plug a giant, $3 trillion, solvency shortfall.

Conclusion

I believe the inclusion of the RMB in the SDR is more than simply symbolic. It will allow the PBoC to move away from a US$ peg, widen it trading bands and balance its currency more effectively relative to its main trading partners. PBoC Intervention can be generally confined to SDR currencies which, due to their high liquidity, will be the cross-currency pairs of choice for speculators.